This is a guest post by Mr Credit Card from askmrcreditcard.com. Though Mr Credit Card reviews credit cards, today, he is going to bring us back in time and explore the history of money and the Federal Reserve Bank and why we should be worried about the dollar. If you are looking to apply for a credit card, consider checking out his list of best credit cards page.

Not too long ago, I spotted a post on Weakonomics about whether you would prefer a strong or a weak dollar. Many personal finance writers like to talk about small issues revolving around frugality. But most are missing the big picture about the effect the potential demise of the US dollar would have on our personal finances. Passive investing, buy and hold, knowing the ins and outs about your 401k ain’t going to do much good if the dollar continues to decline year after year and your purchasing power declines. Weakonomics is one of the few blogs that actually discusses these issues and I would like to expand on that.

A brief history of money and fractional reserve banking system – To understand the situation we are in, we have to first understand the history of money. In the beginning, the primary means of trading was through the barter system. So if I grew apples and wanted to have a medium rare steak for dinner, I had to go to the farmer with the cows and hope that he or she is in the mood for apples. Clearly, the old barter system was a cumbersome process. So we evolved into a system of using “money”. In the beginning sea shells, even herds of cows were used as money and stores of wealth. Then silver and gold coins were made and became money.

When society used money as a medium of exchange, life got better. It was much easier to trade since rather than having to find a producer of the goods you want who also wanted what you had to offer, households and producers could sell their goods for a common “currency”. Trade prospered and society became better off. Soon, the default currency or “store of wealth” became gold and silver coins because they were durable and lasting.

There was only one problem with carrying lots of coins and that is you can be robbed. You could even be robbed at home! So to get around this households started depositing their gold with “gold bankers”. In return, they got “gold certificates”. And they were charged for this convenience, much like a charge card. Different “gold bankers” issued different certificates but soon, these were widely accepted and were more convenient for folks. Once again, trade and commerce flourished even more.

Beginnings of the Fractional Reserve System – Very soon, these gold bankers realized that folks actually keep their gold with them for longer periods than they thought and although they used their “gold receipts”, there was also excess gold in their deposits. They realized that they can actually make money by “lending money” in the form of gold receipts in excess of the gold reserves that they have. They would charge interest to the borrower and as long as the borrower returned their money, everything was fine. Everything was fine as long as no one wanted all their gold at once (like a run on the bank).

Thus, it was the start of the fractional reserve banking system where there was more money circulating in the economy than there was “reserves” (whatever it may be). Left to the free market, bankers will lend an amount of money in which factoring in some potential defaults, they will still make money. So if a banker finds that more of their borrowers are defaulting, they will raise their lending rates to discourage lending and will stop lending to these folks until they can return their businesses to profitability. When borrowers are profitable, “bankers” can afford to lend more and hence interest rates would be lower as they encourage more borrowing.

Creation of the Federal Reserve Bank – Throughout history, there were many instances of liquidity shortages. This has led many countries to have a “central bank” whose function was to be the lender of last resort. After the stock market panic of 1907 where many brokers were on the verge of going under due to margin calls, the Federal Reserve was formed in 1913 for the sole purpose of being the lender of last resort in any “liquidity crisis”. The United States was actually the last industrialized nation to have a central bank with the function of being the lender of last resort. In the terminology used then, money supply was supposed to be “elastic”, being able to expand and contract based on the demand and supply situations. However, after the outbreak of World War I and the breakup of the gold standard in Europe, the FED began to take on a more active role and gave themselves the right to control domestic money market conditions. They did so by conducting “money market operations”, in effect setting interest rates and increasing or decreasing money supply as seen fit. So while the gold standard was maintained after the second world war until 1971, the FED had in fact given itself the license to print money “outside of liquidity crisis”. And print money they did to finance all the government programs throughout the last century.

While money supply was supposed to declined when the economy contracted and expand when the economy grew, the FED soon began a new doctrine that if they could simply keep increasing the money supply during economic slowdown, they could prevent or lessen the effects of recessions. So money supply expanded during the good times and expanded more during the bad times. More money supply equates to a currency that is continually being devalued and the small “acceptable inflation” that we see every year eventually results in a massive decline in our purchasing power. The massive supply of money has resulted in inflation in real estate, stocks, financial assets. Low interest rates made it harder for savers to save and forced banks to invent new “derivatives” to earn extra yield! The presence of 0% APR balance transfer offers or low interest rate credit cards in single digits would never have happened if not for inflationary policies of the last century.

The World’s Reserve Currency – A blessing or a Curse? – To compound these problems, the US dollar is also (at least it still is) the global currency of choice in international trade and commerce. This happened after the Brenton Woods agreement after World War II. While it gave the US huge political power, it was also a curse. It allowed us to run huge federal deficits without being penalized (at least for now). The reason is because trade was conducted in US dollars, countries with trade surpluses (export more than import – same as earn more than you spend) had savings in our currency. Hence, they invested it in US treasury bills. We, on the other hand, had trade deficits (imported more than we exported – ie spend more than we made). Most countries would have to pay higher and higher interest rates if they keep running budget deficits. But we got away with it because of our currency status. But that also means that we have piled up massive debt ($12 trillion and going up). Sooner or later, the world will realize (if they have not already) that there is no way we are going to be able to repay all this debt without resorting to currency devaluation. Lenders will demand higher interest rates (and watch what happens to the housing market when that happens).

Inflationary Policy Encourages Debt – Any economics student will tell you that inflation benefits borrowers because they will be paying back their loans in depreciated currency or their assets that they have purchases would have inflated to a higher value. So why are we in so much debt (both Federal and Personal debt)? Because a monetary policy of constantly injected money supply into the system results in inflation and encourages debt and discourages savings. So in a sense, you can say we are only acting rationally based on the economic situation and policy.

Implications for our personal finances – While it is good to practice good financial habits like reducing credit card debt, saving for your retirement, being frugal, I think you should also make an effort to understand the history of money and have a contingency plan if the dollar collapses and inflation rears its ugly head. What can you do? Here are a few ideas:

• If you need to be in stocks, make sure you have international exposure and your US stocks have overseas presence and earning power
• Consider diversifying your cash to some foreign currency. Some places like Everbank allow you to purchase CDs in various global currencies.
• Have some commodities and gold in your portfolio as a hedge
• Consider stocking up some food supplies in case prices go out of control

I could go on and on about this topic and many books have been written about this. But I simply urge everyone to give this topic some serious thought. Because if you speak to folks in countries which have faced massive currency devaluations and inflation, they will tell you that even if you saved and did all the right things, your wealth could be wiped out instantly.

By The Weakonomist

The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics.

categories: banking, economics, government, investing, personal finance